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Review of Key Concepts in Company Valuation (McKinsey)



Subject: Overview of core valuation principles, methodologies, and practical considerations



I. Core Valuation Methodologies




• Discounted Cash Flow (DCF): The source emphasizes DCF as the most accurate and flexible method for valuing companies. The fundamental principle is to discount projected future cash flows to their present value. The total value is derived from the sum of discounted cash flows over an explicit forecast period and a continuing value.


• Free Cash Flow (FCF): DCF typically involves discounting free cash flow (FCF).


• Economic Profit (EP): Alternatively, a company can be valued by "discounting its projected economic profit at the cost of capital and adding the starting invested capital." The present value of economic profit for a growing perpetuity is calculated as "economic profit in year 1 divided by the cost of capital minus the growth rate."


• Capital Cash Flow (CCF): This method combines FCF and interest tax shields, discounting the combined flow at the same cost of capital (matching the WACC assumptions). The source states that "the capital cash flow and WACC-based valuations will lead to identical results."


• Tax Shields: The treatment of interest tax shields distinguishes the WACC, APV (Adjusted Present Value), and CCF methods. WACC incorporates the tax shield in the cost of capital, APV values it separately, and CCF includes it in the cash flow.


• Multiples: Using multiples (relative valuation) can provide insights and serve as a "great check on your DCF valuation if done properly." However, they are "often used in a superficial way that leads to erroneous conclusions." Proper use involves using forward earnings estimates, adjusting for nonoperating items, and using the "Right Peer Group" with similar economics.


• Types of Multiples: Commonly used multiples include earnings multiples (e.g., Net Enterprise Value divided by Adjusted EBITA or NOPAT), Revenue multiples, and multiples based on operating metrics (e.g., value per barrel of oil reserves, value per paying user/subscriber).


• Limitations of Operating Metrics Multiples: Effective use requires the metric to be a "reasonable predictor of future value creation and thus somehow tied to ROIC and growth." Simply averaging multiples from "apparently similar businesses provides little, if any, insight" if the underlying business models and economics differ significantly (as illustrated by the Netflix, Spotify, and Sirius XM example).




II. Key Value Drivers and Performance Analysis




• Return on Invested Capital (ROIC) and Growth: The source highlights ROIC and organic revenue growth as primary drivers of value. Analyzing historical financial performance involves focusing on "the operating performance of the company and its ability to create value."


• Economic Profit as a Measure: Economic profit captures both ROIC and growth.


• Detailed Revenue Forecasting: Revenue forecasts can be built using "top-down" (total market size, market share, pricing) or "bottom-up" (customer demand projections, customer turnover, new customers) approaches. Using both methods can help "establish bounds for the forecast." A "fine-grained look at a company’s sources of growth will make clear what drives the company’s valuation."


• Value Driver Trees: These tools can provide "additional insight into what has been driving same-store sales for each company," breaking down performance into contributing factors (e.g., transactions per store, revenues per transaction).


• Short-, Medium-, and Long-Term Value Drivers: To safeguard long-term health, companies should identify and set targets for various value drivers across different time horizons:


• Short-term: Immediate drivers of ROIC and growth (e.g., sales volume, cost per unit, transaction volume).


• Medium-term: Performance of existing products/services in existing markets (e.g., customer acquisition and retention, price setting, innovation).


• Long-term: Broader strategic choices and capabilities (e.g., new product development, entering new markets, building distinctive capabilities).




III. Capital Structure and Financing Considerations




• Financing Operations: The analysis of historical performance includes focusing on "how the company has financed its operations," examining the proportion of debt versus equity.


• Sustainability and Risk: Key questions include whether the capital structure is sustainable and if the company can survive downturns.


• Liquidity Measures: Coverage ratios (using EBITA and EBITDA) are used to "estimate the company’s ability to meet short-term obligations."


• Leverage Assessment: This involves me...